Fed watch

However, given that price pressures still appear to be rising while the economy remains fairly firm (Aug. 30 second quarter U.S. GDP is likely to be revised higher), the risk is the Fed resumes its rate hiking campaign. Prior to the release of the U.S. August employment data in early September, the fed funds futures (FF) are pricing in only a slim chance of a Sept. 20 FOMC rate hike.

Assuming the Fed saying it wants to monitor the impact choice, but a rate hike at that meeting cannot be dismissed on political grounds. To avoid politicizing monetary policy requires ignoring the electoral cycle completely, and taking action if required.

In the late 90s, former Fed Chairman Alan Greenspan consciously engaged in a growth experiment. Under his leadership, the Federal Reserve refrained from hiking interest rates (even if the strength of the economy would have suggested doing so) on the grounds that price pressures would be kept in check by rising productivity and international competition. It is as if Greenspan was breaking from the Philips Curve, which posits a trade off between employment and inflation.

Current Chairman Ben Bernanke appears to be steering the Fed back to embracing the Philips Curve. The main case for not raising interest rates in August was the idea that cooling economic activity will bring price pressures back to more acceptable levels. The subdued inflation at the end of 2005 points to further acceleration of the year-over-year pace in coming months.

Given the U.S. is the world’s largest debtor, the market may not be patient for very long with Bernanke’s bet. But even if the Fed decides to raise rates once or twice more in the period ahead, the dollar might not benefit very much.

Both this analysis of the dollar’s political cycle and an earlier argument regarding the interest-rate cycle (see “The dollar’s super-cycle,” Currency Trader, March 2006) warn of downside risks for the dollar. The premium offered by the U.S. over the Eurozone (using the front-month Eurodollar and Euribor futures contracts) peaked in June and narrowed by more than 30 basis points by the end of August.

Additional Fed rate hikes now might not have the same dollar supportive impact because they would likely be seen as the Fed slipping behind the curve (reactionary hikes rather than proactive), very late in the cycle, and perhaps even bringing forward the first cut.

Our experience with floating exchange rates is not sufficient to draw any hard and fast conclusions about the impact of the U.S. electoral cycle on the dollar. These preliminary findings suggest that to the degree there are some regularities, they are strongest during the second year of a president’s term and biased toward the dollar’s downside.

During the third year, the dollar alternated between rising and falling in each period — a pattern that would imply the dollar is poised to rise next year.

That said, there is sufficient variability in the data that, even if the U.S. political cycle actually has some influence on the dollar, it is in no way a substitute for prudent and disciplined risk management.